After Years of Overconstruction, Could Steel Demand Buckle in China?

Summary

We expect downside risks to steel demand to continue to materialize, as past housing construction growth rates are unsustainable amid constrained infrastructure spending growth in China. Other end users are also unlikely to propel China’s steel demand.

Pressure in the markets for iron ore and metallurgical coal will likely make a meaningful recovery in prices difficult.

In the absence of Chinese steel demand growth, we expect steel production overcapacity will persist in China and continue to remain a headwind to global steelmakers amid export pressures.

The years of huge growth in China’s housing development market are over, spelling tough times over the long-term horizon for global steelmaking. We expect downside risks to steel demand to continue to materialize, as past housing construction growth rates are unsustainable amid constrained infrastructure spending growth in China. Headwinds will also continue for steelmaking raw materials like iron ore and metallurgical coal, while countries that derive a large portion of their export value from these materials – Australia and Brazil in particular – will likely experience pressure on their terms of trade and, potentially, their currencies.

In evaluating the outlook for Chinese steel demand, the most important sector is the construction industry, which accounted for an estimated 50%–60% of China’s 2013 steel demand, coming from both property and infrastructure (see Figure 1).

China’s housing construction to run out of steam
Our analysis suggests that cumulative housing built from 2000 to 2014 can rehouse 42% of China’s population. Assuming 2014’s level of construction activity continues, by 2018 this ratio will reach 64% (see Figure 2). We believe this level of growth is unlikely to be able to continue. Meanwhile, Chinese households are starting to diversify their investments away from the housing sector, which has historically propped up the demand for private housing. In a 2013 independent survey by a leading academic on Chinese households, Li Gan, investment demand was the motivation behind around 50% of housing purchases.

Other factors also point to declining demand for housing over the secular horizon. According to a 3 December 2014 Morgan Stanley research report, China’s dependency ratio bottoms out in 2015 due to its one-child policy. This creates excess housing supply because each set of parents can leave their housing to a younger couple. While the supply/demand dynamics for housing differ regionally, the oversupply has been most prominent in lower-tier cities. This suggests that developers can no longer push for sales in areas that are simply not ready to be occupied. Meanwhile, the more attractive regions like the tier 1 and tier 2 cities with actual demand are likely to be too expensive for many.

Infrastructure construction growth will likely slow
Given the challenges in the property market, infrastructure construction was critical in supporting Chinese steel consumption in 2014. In our opinion, there are still areas where infrastructure needs to be built – such as urban transportation systems and environmental management – to sustain China’s GDP growth. And capital formation on a per capita basis is still low compared with that of more developed countries.

But growing infrastructure spending has limitations. Historically, local governments have depended on the availability of credit and the ability to borrow to increase their infrastructure spending. Given already-high local debt-to-GDP ratios and inadequate returns on past infrastructure investments to allow for meaningful deleveraging, we believe it will be difficult for local governments to take on more new debt (see Figure 3).

In addition, with the high levels of fixed capital formation as a percentage of current Chinese GDP, where infrastructure spending (and credit growth) has become an important driver in recent years, we believe that infrastructure spending growth must slow in the coming years (see Figure 4). While we are not expecting an outright decline, which would have painful ramifications for Chinese GDP growth, we believe previous levels of infrastructure spending growth rates will be difficult to sustain.

Other users of steel are unlikely to prop up demand
While there are other end users of steel – including machinery, autos and white goods – they are unlikely to propel China’s steel demand, in our view.

Historically, machinery production has been well-correlated with construction activity. We expect the knock-on impact from slower construction activity to limit growth in machinery production in the coming years.

Auto production is a brighter spot for Chinese steel demand, as we expect production to increase 5% annually going forward. Chinese auto penetration is still low at 7% (versus 44% in the U.S.) and is projected to rise as incomes continue to grow. However, the impact on steel demand will only be moderate, as demand from the auto industry is estimated to have contributed only around 6%–7% to China’s apparent steel consumption in 2013.

As incomes in China continue to grow, demand for white goods such as household appliances is also likely to rise. While property demand may not be as strong as before, we believe upgrading needs and new technologies may continue to drive demand in this area. Given demand for steel from the appliances segment is estimated to have contributed only around 2% to Chinese steel consumption, the impact of demand growth from this segment will also only have a moderate impact on overall Chinese steel demand.

Raw materials prices to stay low
We expect headwinds will continue for iron ore and metallurgical coal, making a meaningful recovery in prices difficult. Meanwhile, the surge in seaborne iron ore supplies means it will be a while before supply is able to rebalance via the elimination of higher-cost producers, given that growth potential in end-user demand is limited over the secular horizon and that iron ore prices have yet to find a true floor. In a market with excess supplies, rampant cutting on production costs and depreciating currencies of producing regions, we believe marginal cost provides little pricing support. Meanwhile, we believe production from Chinese iron ore miners may be stickier than markets expect. Given the pressure on Chinese steel consumption potential, we see the long-term equilibrium for iron ore prices (62% content, CFR China) to trade at $60–$70 per dry metric ton after all the new production is digested – something that is unlikely to take place until 2017. However, in the interim, as the seaborne iron ore market continues to digest the increase in production volumes, we see pressure for the spot iron ore price to undershoot our long-term floor price of $60 per dry metric ton.

In addition, countries like Australia and Brazil, which have a large portion of their export value coming from steel-making raw materials, will likely experience further downside to their terms of trade and a potential negative impact on their currencies. On a relative basis within the seaborne iron ore market, however, we expect the Australian producers to be better positioned because their proximity to key steel-producing regions (namely Asia) allows them to capture better pricing when prices are falling.

Steel production overcapacity is likely to persist in China
We believe there is very limited growth potential for Chinese steel demand going forward. While China’s interest rate cut last November may be a positive catalyst for the housing market and we expect more rate cuts could come, we believe this could translate to, at best, single-digit growth for property sales and low-single-digit growth for steel demand in 2015. Moreover, housing starts data in China for December 2014 showed a deceleration after the November rate cut, suggesting that property developers are still focusing on destocking housing inventory.

We believe infrastructure spending growth will continue but at a slower rate, given the financial constraints local governments are working with. The ongoing probes on corruption by government officials may also have the unintended effect of slowing infrastructure project approvals this year.

In the absence of Chinese steel demand growth, steel production overcapacity will persist in China and continue to remain a threat to global steelmakers amid export pressures. Moreover, the Chinese government has shown little desire to consolidate the domestic steel industry, and even if consolidation were to happen, the process would likely be long and painful.

Overall, we expect steel companies to be relative winners over the short term due to lower raw-material costs. But longer term – absent industry reforms and drives for consolidation – overcapacity in Chinese steel production will continue to plague the industry. Globally, the steel industry also faces increasing exports of low-value-added steel from countries whose currencies have significantly depreciated, like Russia and even Japan. This will disproportionately affect steelmakers with high exposure to this category of steel production and distort supply dynamics further.

Summary

We expect downside risks to steel demand to continue to materialize, as past housing construction growth rates are unsustainable amid constrained infrastructure spending growth in China. Other end users are also unlikely to propel China’s steel demand.

Pressure in the markets for iron ore and metallurgical coal will likely make a meaningful recovery in prices difficult.

In the absence of Chinese steel demand growth, we expect steel production overcapacity will persist in China and continue to remain a headwind to global steelmakers amid export pressures.